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Destabilizing Speculation and the Case for an International Currency Transactions Tax
Challenge, May, 2001 by Thomas Palley
Similar damage had been inflicted on U.S. manufacturing fifteen years earlier when the dollar underwent a prolonged period of overvaluation that made U.S. manufacturing internationally uncompetitive. In the United Kingdom there were similar problems in the early 1980s and the late 1990s, when the pound sterling appreciated, thereby making British manufacturing uncompetitive.
Finally, for much of the 1980s Europe's economy was adversely impacted by governments' fear of a currency crisis. To avoid it, many European governments raised interest rates to shore up their currencies, but the result was higher unemployment. Though the introduction of the euro has helped reduce this problem by reducing the scope for currency crises among small European economies, it does illustrate how even developed countries can be hurt by currency market speculation.
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Why the Tobin Tax Can Help Reduce Harmful Speculation
Before detailing how the Tobin tax can help reduce disruptive speculation, it is worth making two important points. First, a Tobin tax will work best when introduced as part of an overall financial architecture, which is why proponents usually present it as part of a package of reform measures. This feature reflects the fact that policy measures often exhibit synergies so that the whole is frequently greater than the sum of the parts.
Second, the Tobin tax and other measures to reduce disruptive speculation do not prevent bad outcomes resulting from bad policy. For instance, a major reason for the damaging appreciations of the dollar and the pound sterling in the 1980s was tight monetary policy in the United States and United Kingdom respectively. These policies raised interest rates and attracted an inflow of foreign capital that appreciated the exchange rate. This result would have been likely even in the presence of a Tobin tax, though it is possible that the inflows would have been marginally dampened.
Similarly, a Tobin tax would not prevent exchange-rate collapses resulting from government attempts to maintain fixed exchange rates that are massively overvalued relative to the rate warranted by economic fundamentals. Critics of the Tobin tax often point to the fact that the tax is so small (0.1 percent) that it would not deter speculators from attacking overvalued fixed exchange rates where they anticipate double-digit percent gains. However, such criticism misses the point. The Tobin tax is not intended to prevent speculation resulting from massive policy-induced exchange-rate overvaluation. Instead, it is intended to prevent groundless speculation that increases noise in financial markets and imposes costs on other sensible investors.
The traditional "Chicago school" view of speculation is that it is stabilizing (Friedman 1953). This point of view is predicated on the argument that there exists a market price that is warranted by economic fundamentals. When the actual price exceeds this warranted price, speculators realize that the market is overvalued. They therefore sell, and drive the market down to its warranted price. Conversely, when the actual price is below the warranted price, speculators realize the market is undervalued. They therefore buy and drive the market up to the warranted price.
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